CHAPTER - ONE

RISK AND RELATED TOPICS

Introduction
The future cannot be predicted. It is uncertain, and no one has ever been
successful in forecasting the stock market, interest rates, or exchange rates
consistently—or credit, operational, and systemic events with major financial
implications. Yet, the financial risk that arises from uncertainty can
be managed. Indeed, much of what distinguishes modern economies from
those of the past is the new ability to identify risk, to measure it, to appreciate
its consequences, and then to take action accordingly, such as
transferring or mitigating the risk.

1.1 Definition of risk.

Risk provides the basis for opportunity. The terms risk and exposure have
subtle differences in their meaning. Risk refers to the probability of loss, while
exposure is the possibility of loss, although they are often used
interchangeably. Risk arises as a result of exposure.

Risk is the likelihood of losses resulting from events such as changes

in market prices. Events with a low probability of occurring, but that may
result in a high loss, are particularly troublesome because they are often
not anticipated. Put another way, risk is the probable variability of returns.

Since it is not always possible or desirable to eliminate risk, understanding it is

an important step in determining how to manage it. Identifying exposures and
risks forms the basis for an appropriate risk management strategy.

Risk is the possibility that a loss or injury will occur.

It is impossible to escape all types of risk in today’s world. For individuals,

driving an automobile, investing in stocks or bonds, and even jogging along a
country road are situations that involve some risk. For businesses, risk is a
part of every decision. In fact, the essence of business decision making is
weighing the potential risks and gains involved in various courses of action.

There is obviously a difference between, say, the risk of losing money one has
invested and the risk of being hit by a car while jogging. This difference leads to
the classification of risks as either speculative or pure risks.

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1.2. RISK Vs UNCERTAINTY
The dictionary meaning of risk is “the possibility of meeting danger or suffering
harm or loss”. The dictionary meaning of uncertainty is “the state of being
uncertain”. Here, uncertain means “feeling doubt about”. Thus, uncertainty of
meeting with a loss or damage is known as risk. Although risk is defined as
uncertainty, employees in the insurance industry often use the term risk to
identify the property or life being insured.
1.3 RISK & PROBABILITY
It is necessary to distinguish carefully between risk and probability. Probability
refers to the long run chance of occurrence, or relative frequency of some event.
Probabilities are generally assigned to events that are expected to happen in
the future.
There may be a number of possible events that will take place under given set
of conditions and these events may occur in equal or different chance of
occurrence. For a clear differentiation between them, let see the following
example. Suppose the occurrence of a particular event is to be considered. One
extreme is that this event is certain to occur. Thus the probability that this
event will take place is 1(one). In this case there is no risk. In the other extreme
the event will not take place at all. Hence the probability of occurrence is zero.
In this case also there is no risk. In between these two extremes there could be
several occurrences of the events with the corresponding probabilities of
occurrence. This puts us in a situation of uncertainty because it is difficult to
exactly tell which of the many possible events will take place. So that under
this situation there is risk.
Chance of loss is closely related to the concept of risk. “Chance of loss” is
defined as the probability that an event will occur. Probability has both
objective and subjective aspects.
Objective Probability:
Objective probability refers to the long-run relative frequency of an event based
on the assumptions of an infinite number of observations and of no change in
the underlying conditions.
Subjective Probability:
Subjective probability is the individual’s personal estimate of the chance of
loss. It need not coincide with objective probability. For example, people who
buy a lottery ticket on their birthday may believe that it is their lucky day and
over-estimate the small chance of winning. However, some may think that their

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wedding anniversary day as a lucky day. Thus, a wide variety of factors can
influence subjective probability such as age, sex, intelligence, education, etc. In
subjective probability, a person’s estimate of loss may differ from objective
probability because there may be ambiguity in the way in which the probability
is perceived.
1.4 Risk, peril and hazard
 Risk is uncertainty concerning the occurrence of a loss or events which
might produce a loss (an event).
 Peril is defined as the cause of loss. If a house burns because of fire, the
peril (the cause of loss) is the fire. Likewise, some common perils that
cause damage or loss to the property include lightening, windstorm,
tornadoes, earthquakes, theft and burglary.
 Hazard- A condition which lies behind the occurrence of a loss.

 Could increase frequency.

 Could increase severity.

It classified as
 A physical hazard
 It is a physical condition that increases the frequency or severity of
loss.
 Moral hazard
It is dishonesty or character defects in an individual that increase the
frequency or severity of loss. For example, the dishonest persons may fake an
accident to collect the insurance or they intentionally burn unsold
merchandise that is insured.
Moral hazard is present in all forms of insurance and it is difficult to control.
Dishonest individuals often rationalize their actions on the ground that “the
insurer has plenty of money”. However, this view is incorrect because the
insurer can pay claims only by collecting premiums from other insured.
Because of moral hazard, premiums are higher for everyone.
 Morale Hazard:
Morale hazard is slightly different from the moral hazard. Moral hazard refers
to dishonesty by an insured that increases the frequency or severity of loss.
Morale hazard is carelessness or indifference to a loss because of the existence
of insurance. Examples of morale hazard include leaving a door unlocked that
allows a burglar to enter, rash driving without proper signaling. Careless acts
like these increase the chances of loss.

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  Legal Hazard
Refers to characteristics of the legal system or regulatory environment that
increase the frequency or severity of loss.
1.5 Classification of risk

1. Static and Dynamic Risks

Dynamic risks are those resulting from changes in the economy. Changes in
the price level, consumer tastes, income and output, and technology may cause
financial loss to members of the economy. These dynamic risks normally
benefit society over the long run, since they are the result of adjustments to
misallocation of resources. Although these dynamic risks may affect a large
number of individuals, they are generally considered less predictable than
static risks, since they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no
changes in the economy. If we could hold consumer tastes, output and
income, and the level of technology constant, some individuals would still
suffer financial loss. These losses arise from causes other than the changes in
the economy, such as the perils of nature and the dishonesty of other
individuals. Unlike dynamic risk, static risks are not a source of gain to
society. Examples of static risks include the uncertainties due to random
events such as fire, windstorm, or death. Static losses involve either the
destruction of the asset or a change in its possession as a result dishonesty or
human failure. Static losses tend to occur with a degree of regularity overtime
and, as a result, are generally predictable. Because they are predictable, static
risks are more suited to treatment by insurance than are dynamic risks.

Generally, it involves those losses that would occur even if there were no
changes in the economy. These losses arise from causes other than the
changes in the economy such as the perils of nature.

2. Fundamental and Particular Risks

The distinction between fundamental and particular risks is based on the

difference in the origin and consequences of the losses.

A fundamental risk is a risk that affects the entire economy or large numbers
of persons or groups within the economy. Fundamental risks involve losses
that are impersonal in origin and consequence. They are group risks, caused

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for the most part by economic, social and political phenomena, although they
may also result from physical occurrences. They affect large segments or even
all of the population. Examples of fundamental risks include high inflation,
cyclical unemployment & war, drought, earthquakes, floods and other natural
disasters.

Examples include high inflation, the risk of a natural disaster is another

important fundamental risk. Tornadoes, earthquakes, floods and forest fires
can result in property damage as well as the loss of numerous lives.
A particular risk is a risk that affects only individuals and not the entire
community. Examples are car thefts, bank robberies, etc. Here, only
individuals experiencing such losses are affected, not the entire economy. The
distinction between a fundamental and particular risk is important since
government assistance may be necessary to insure a fundamental risk. Social
insurance and government insurance programs, as well as government
guarantees and subsidies, may be necessary to insure certain fundamental
risks. For example, the risk of unemployment generally is not insurable by
private insurers but can be insured publicly by State Unemployment
Compensation Programs.

Note: - Particular risks involve losses that arise out of individual events and
are felt by individuals rather than by the entire group. They may be static or
dynamic. Examples of particular risks are the burning of a house, the robbery
of a bank, and the damage of a car.

3. Objective and Subjective Risks

Objective risk is defined as the relative variation of actual from expected loss.
Objective risk, or statistical risk, applicable mainly to groups of objects exposed
to loss, refers to the variation that occurs when actual losses differ from
expected losses. For example assume that a property insurer has 10,000
houses insured over a long period and, on average, 1 percent, or 100 houses,
burn each year. However, it would be rare for exactly 100 houses to burn each
year. In some years, as few as 90 houses may burn, while in other years, as
many as 110 house my burn. Thus, there is a variation of 10 houses from the
expected number of 100, or a variation of 10 percent. This relative variation of
actual loss from expected loss is known as objective risk.

Subjective risk is defined as uncertainty based on a person’s mental condition

or state of mind. A subjective risk is a psychological uncertainty that stems

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from the individual’s mental attitude or state of mind. Some writers have used
the word “uncertainty” to be synonymous with subjective risk as defined here.
Subjective risk has been measured by means of different psychological tests,
but no widely accepted or uniform tests of proven reliability have been
developed. Thus, although we recognize different degrees of risk-taking
willingness in persons, it is difficult to measure these attitudes scientifically
and to predict risk-taking behavior, such as insurance-buying behavior, from
test of risk-taking attitudes.

Degree of Risk

Degree of risk is the range of variability around the expected losses, which are
calculated using the chance of loss concept by means of the following formula:
¿
Objective risk = Probable variation of actual ¿ expected losses Expected losses

Consider the possibility of fire losses to buildings in towns A and B. There are
100,000 buildings in each town and, on average; each town has 100 fire losses
per year. By looking at historical data from the towns, statisticians are able to
estimate that in town A the actual number of fire losses during the next year
will very likely range from 95 to 105. In town B, however, the range probably
will be greater, with at least 80 fire losses expected and possibly as many as
120. The degree of risk for each town is computed as follows

105−95
Risk A = =10 percent
100

120−80
Risk B = =40 percent
100

As shown, the degree of risk for town B is four times that for town A, even
though the chances of loss are the same. Chance of loss is expressed as the
ratio of the number of losses that are likely to occur compared to the larger
number of possible losses in a given group.

4. Speculative and pure risk

Pure risk is defined a situation in which there are only the possibilities of loss
or no loss. The only possible outcomes are adverse (loss) and neutral (no loss).
A pure risk exists when there is a chance of loss but not chance of gain. For
example, the owner of an automobile faces the risk associated with a potential
collision loss. If a collision occurs, the owner will suffer a financial loss. If there

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is no collision, the owner does not gain. The owner’s position remains
unchanged. Other examples of pure risks include premature death, job-related
accidents, and damage to property from fire, lighting, flood, or earthquake.

The only possible outcomes are adverse (loss) and neutral (no loss). Examples
of pure risks include premature death, job-related accidents, etc.
Types of Pure Risk:
The following are the important types of pure risks;
A. Personal risks: - Personal risks are risks that directly affect an
individual. Examples of personal risks are possibility of the complete
loss or reduction of earned income, extra expenses, etc. There are four
major personal risks.
i. Risk of premature death: - Risk of premature death is defined as the
death of a household head with unfulfilled financial obligations. The
obligations may be dependents to support, a mortgage to be paid off
or children to educate. If the surviving family members receive an
insufficient amount of replacement income from other sources, they
may be financially insecure. Premature death can cause financial
problems only if the deceased has dependents to support or dies with
unsatisfied financial obligations. Thus, the death of a child age 10 is
not “premature” in the economic sense.
ii. Risk of insufficient income during retirement: - Risk of insufficient
income during the retirement; is another major risk associated with
old age. The majority of workers retire before age 65. When they retire,
they lose their earned income. Unless they have sufficient financial
assets, or have access to other sources of retirement, they will be
exposed to financial insecurity during retirement.
iii. Risk of poor health: - Risk of poor health is another important
personal risk. The risk of poor health includes both the payment of
medical bills and the loss of earned income. The costs of major
surgery have increased substantially in recent years. For example, an
open heart surgery can cost more than 50,000 Birr, a kidney
transplant can cost more than 30,000 Birr. Unless these persons
have adequate health insurance, private savings, and financial assets,
or other sources of income to meet these expenditures, they will be
financially insecure.
iv. Risk of unemployment: - Risk of unemployment is another major
threat to financial security. Unemployment can result from business

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 cycle downswings, technological & structural changes in the economy,
etc. Unemployment can cause financial insecurity in three ways;
 First, the worker loses his or her earned income.
 Second, because of economic conditions, the worker may be able to
work only part time.
 Finally, if the duration of the unemployment is extended a long
period, past savings may be exhausted.
B. Property risks
Persons owning property are exposed to the risk of having their property
damaged or lost from numerous causes. Personal property can be damaged
because of fire, lightning, windstorms and numerous other causes.
There are two major types of loss in the damage of property;
i. Direct loss: - A direct loss is a financial loss that results from the
physical
damage, destruction, or theft of the property, such as fire damage
to a home.
ii. Indirect loss: - An indirect or consequential loss is a financial loss that
results indirectly from the occurrence of a direct physical damage or
theft
loss, e.g., the additional living expenses after a fire.
C. Liability risks involve the possibility of being held legally liable for
bodily
injury or property damage to someone else.
The court of law may order that person to pay substantial damages to
the person who is injured. Motorists are being held legally liable for the
negligent operation of their vehicles. Producers are also being sued
because of defective products that harm or injure customers.
Speculative Risk is defined as a situation in which either profit or loss is
possible. A speculative risk exists when there is a chance of gain as well as a
chance of loss. For instance, investment in a capital project might be profitable
or it might prove to be a failure. If you purchase 100 shares of common stock,
you would profit if the price of the stock increases but would lose if the price
declines. Other examples of speculative risks are betting on a football match,
investing in real estate, and going into business for yourself. In these
situations, both profit and loss are possible.

 A speculative risk is a situation in which either profit or loss is possible

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For example, if Mrx. Purchases 100 shares of a company, he would gain if the
price of that share increases but would lose if the price declines. Thus, here
there are possibilities of both profit and loss.

Speculative risk can be differentiated from the pure risk in three ways;

I. Private insurers generally insure only pure risks. Speculative risks are not
considered insurable and other techniques must use to cope with risk.
However, there are certain exceptions. One exception is that some insurers will
insure institutional portfolio investments and municipal bonds against loss.

II.The law of large numbers can be applied more easily to pure risks than to
speculative risks. The law of large numbers is important because it enables
insurers to predict loss in advance. But, it cannot be applied to speculative
risks in order to predict future loss experience. An exception is the speculative
risk of gambling, where casino operators can apply the law of large numbers in
a most efficient manner.

III.Society may benefit from a speculative risk even though a loss occurs, but it
is harmed if a pure risk is present and loss occurs. For example, a firm may
develop new technology for producing cheaply. As a result, some competitors
may fail. Despite the failures, society benefits since the computers are
produced at a lower cost. However, society does not benefit when a loss from
the pure risk occurs, such as floods, earthquakes, etc.

5. Enterprise risk
 Encompasses all major risks faced by a business firm,
which include: pure risk, speculative risk, strategic risk, operational
risk, and financial risk.

 Strategic Risk refers to uncertainty regarding the firm’s

financial
goals and objectives.
 Operational risk results from the firm’s business operations.
 Financial Risk refers to the uncertainty of loss because of
adverse changes in commodity prices, interest rates, foreign
exchange rates, and the value of money.

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 1.6 Burden of risk on society
Loss of property and money are the primary reason that individuals attempt to
avoid or alleviate its impact and hence these is the primary Burdon on society.
In addition to this risk entails three major burdens on society.
1. The size of an emergency fund will be increased. It is prudent to set aside
funds for an emergency. However, in the absence of insurance individuals and
business firms would have to increase the size of their emergency fund in order
to pay for unexpected losses.
2. Worry and fear are present- the uncertainty connected with risk usually
produces a feeling of frustration and mental unrest. This is particularly true in
the case of pure risk.
3. Loss of certain goods and services-a third Burdon of risk is that society is
deprived of certain goods and services, example, because of the risk of liability;
some corporations have discontinued manufacturing certain goods.
4. In the absence of insurance, individuals and business firms would
have to maintain large emergency funds to pay for unexpected losses.
5. The risk of a liability lawsuit may discourage innovation, depriving
society of certain goods and services.
6. Risk causes worry and fear.

THE END

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